This Company is Still Best in Breed

Adam is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The cat’s out of the bag. (Sorry, I couldn’t resist.) PetSmart (NASDAQ: PETM) reported earnings after the market closed on Wednesday. The company absolutely blew analyst estimates of $0.63 out of the water with earnings of $0.75 per share for the third quarter. That number represents a 50% increase in earnings from the same period a year ago.

While the company far exceeded expectations in net income, it only moderately beat revenue estimates. For the third quarter, PetSmart took in $1.63 billion in sales compared to estimates of $1.60 billion. Better than expected profit margins made up the difference.

Earlier this week, I wrote an article outlining four things to look for in the PetSmart’s earnings report. PetSmart is facing increased competition from the likes of Wal-Mart (NYSE: WMT) and Amazon (NASDAQ: AMZN), and there are a few key areas that will indicate the company’s success in fending off those big retailers.

Let’s see how the company did, and what the outlook is for its future based on this most recent piece of information.

1)      Gross Margin

Gross margin improved 100 basis points over the same period a year ago, with PetSmart reporting a gross margin of 29.6% for the third quarter. While the company had reported a gross margin over 30% for the previous three quarters, this is still a surprisingly high number. In my previous article, I said I would be happy seeing a number above 29.3%, and this report surely outdoes that mark.

Maintaining high gross margins indicates that PetSmart is not succumbing to pricing pressure from retailers like Wal-Mart and Amazon, which often have very aggressive pricing. The fact that the company continues to grow sales without sacrificing pricing is a good indicator the it is outdoing the competition in bringing in and retaining customers.

2)      In-Store Service Sales

In-store service sales increased 8.6% year over year, but fell 10 basis points as a percentage of total revenue. Services made up 10.7% of total revenues for the third quarter. Comparatively, service sales made up 11.8% of revenue in the second quarter, and 10.8% in the third quarter of 2011. Overall, year-to-date service sales are down 10 basis points as a percentage of total revenues.

I do not like this trend. Services are a distinct advantage PetSmart has over Wal-Mart, Amazon, and other general retailers. Additionally, services generally incite repeat customers, which can be a source of recurring revenue. The pet services industry is currently growing faster than pet products, but that is not reflected in PetSmart’s income statement. I’d like to see services become a larger percentage of the company’s revenue in the long run.

3)      High-End Merchandise Sales

While PetSmart doesn’t break down its merchandise revenue into premium and discount products, premium pet products are often sold at higher margins. Looking at gross margins for merchandise sales can help us figure out what’s driving merchandise sales.

In the second quarter, PetSmart raised its gross margin on merchandise sales just 5 basis points. I said I wanted to see a better improvement in the third quarter. This is where PetSmart really delivered. The company reported a gross margin on merchandise of 30.2%; that’s 110 basis points higher than the third quarter last year. Year-to-date gross margin on merchandise are up 100 basis points.

PetSmart started targeting the high-end of the market in 2009. Meanwhile, Wal-Mart and Amazon are going after bargain shoppers with low-priced pet products. If PetSmart can continue to grow sales, I will happily trade away some low-end sales for higher margin premium products.

4)      Same Store Sales Growth

PetSmart reported same store sales growth of 6.5% for the third quarter. Last quarter SSS was 7%, and the company expects next quarter to grow at the same rate. This is a great growth rate compared to the 3% to 5% rate of growth for the industry.

Same store sales removes sales from new stores, and indicates how well PetSmart’s older locations retain customers and bring in new ones. It is the best indicator the company has to show that it’s attracting new customers and fending off the aggressiveness of Amazon and Wal-Mart.

Overall, the latest news from PetSmart is very encouraging. The market agrees, pushing the stock price up nearly 6% after hours. With excellent margins, particularly from merchandise sales, the company handily beat earnings estimates. I would keep an eye on the growth in services, as I’d like to see it generate a larger percentage of total revenue in the long run, but an 8.6% improvement in sales is nothing to sneeze at. I don’t think it’s too late to get on board either, as PetSmart remains the best of breed in a growing retail segment.

adamlevy owns shares of The Motley Fool owns shares of and PetSmart. Motley Fool newsletter services recommend and PetSmart. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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